How some active fund managers are beating the indexes

That may be why most fund managers — and most investors — don’t outperform the indexes they use to represent the market, no matter how hard they try. But a growing body of research suggests that fund jockeys are trying harder these days, in many cases by actually doing less but believing in themselves more.

Moreover, buried in that research are ideas that could help fund investors increase their odds of getting the results they pay for — especially those who prefer active management.

“Active share” is a concept that has been making the rounds in the fund world for several years, a concept that evolved from academia rather than guys who make a living hyping their analytical systems. The idea here is to compare what’s in a fund’s portfolio with what’s in the benchmark that is most appropriate. The more the fund deviates from the index, the higher its score should be — though for complicated reasons that’s not always the case — and funds with higher scores tend to beat those with lower scores.

Since an index fund would have a score of zero if it perfectly replicates the index, the more a manager strays from the index, the better the chances of beating it.

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Chuck Jaffe explains how excitement over California Chrome’s run for horse racing’s Triple Crown is a reminder that investing, in its own way, is a gamble, and that picking a mutual fund is remarkably similar to picking the ponies. Photo: Getty Images.

Consider that Touchstone Large-Cap Growth
TEQAX, +0.00%
, run by money manager Louis Navellier, gets an active share score of 91 when compared with the Russell 1000, according to Touchstone’s own calculations. Without looking at specific names in either portfolio, an investor can quickly understand where the fund differs from the index: Navellier has been holding fewer than 40 stocks in the portfolio, while there are about 625 growth stocks in the Russell 1000.

Over the last seven calendar years — and the active share would have moved around that whole time — the fund beat the benchmark, as represented by the iShares Russell 1000 Growth ETF — in three years and trailed it in the other four.

“If you merely want exposure to large-cap growth funds, investors are best served by buying the [exchange-traded fund],” said Steve Graziano, president of the Touchstone Funds, which recently published a white paper on active share. “If you want exposure to the asset class and want the wherewithal — the chance — to perform better than the average, you need to have something that looks different than the benchmark but that plays in the same space.

“Whether it does or doesn’t perform better comes down to the execution of how one buys and sells stocks and the process the manager uses,” he added. “Being high active share unto itself means nothing more than that the manager has a chance at beating the benchmark.”

According to some new research produced by Nasdaq OMX, the trading flow of funds suggests that active managers are taking steps that, presumably, would increase their active share.

David Levine, global head of investor relations analytics at Nasdaq OMX, reported that turnover — how much of the portfolio turns over in a year — and the number of securities held, bought or sold by equity funds have declined over the last few years, with buying and selling activity off by almost 30%.

You would think that less trading means that fund managers are giving up on trying to beat the index, but the truth is just the opposite, according to Levine.

The decline in trading — at a time when assets are on the rise — and the reduction in portfolio turnover is a sign that active managers “are taking stronger stances, making more and larger bets and holding them longer to let their investment thesis play out.”

For years, financial advisers pushed active managers to make sure their funds performed in a fashion that was consistent with the index fund they could use as a lower-cost alternative; now, it seems, the active managers aren’t being cowed into running closet index funds.

Presumably, that’s good for fund investors; if they want active management, they should get what they are paying for. Otherwise — as noted by Graziano, the top dog at a firm that specializes in active management — they should stick with index ETFs.

Moreover, investors who want to get the most out of an active manager have to give the strategy time to work; be committed to a strategy over the long haul, or commit instead to simply owning the asset class.

“Investors should focus on their needs — what is my time horizon, what is my risk tolerance — and they should think of funds by type, as active, ETF, indexed, and allocate their portfolio accordingly,” said Levine.

“People need to take a slightly longer-term view of their managers and how these things play out,” he added. “Just like the managers themselves have reduced turnover and maybe concentrated their holdings a little more tightly, I think individuals should look at it the same way.”

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